Three Competing Views of the Informal Economy and Economic Development

Although we in the BoP sector often talk about the role of the informal sector as an important factor (both as a competitor and as an ally) when crafting sustainable models for low income communities, precious little has gone into analyzing it. One of the most important reasons for this lack of analysis is because of the shortage of data referring to it. By definition, informal businesses are hidden from the eyes of the state and so most of what we have relies on estimations and very micro-level studies.

A recent cross-country report that appeared in the Brookings Papers on August 2008 aims to improve the understanding of the relationship between economic development and the informal economy. The report, entitled “The Unofficial Economy and Economic Development” is authored by Rafael La Porta and Andrei Schleifer, two renowned professors and scholars in the development studies field.The unofficial economy is estimated to account from 30% to 40% of all economic activity in developing countries and it shrinks in relative terms as the economy develops (for example, because public goods become better and financial markets larger or because avoiding detection becomes harder). The authors distinguish between three alternative views of the role of informal firms in development. The first view is called the romantic view and is associated with the work of Hernando de Soto (whose work, “The Mystery of Capital“, we have quoted/cited here several times).

According to this view informal firms are actually or potentially extremely productive, but held back by government taxes and regulations as well as by the lack of safe property rights and access to finance. If such barriers were lowered, informal businesses would register and take advantage of the benefits of their formal status. Thus, this view assumes that unofficial firms are fundamentally similar to official ones.

The parasite view states that informal firms need to stay small to avoid detection. The decision to remain in the informal economy is a rational one, because the cost advantage of avoiding taxes and regulations allows unofficial firms to undercut official firms in prices. Informal firms are thus hurting growth because their small scale makes them unproductive and because they take away market share from more productive, formal competitors. Government policy should aim to eradicate informal firms by reducing tax evasion and increasing government regulation enforcement.

The dual view also emphasizes the inefficiency of informal firms but takes a different approach. It states that lower educated workers work in informal and smaller firms and receive lower wages, while better educated workers work at larger productive firms and receive higher wages. Productive entrepreneurs pay taxes and bear the cost of regulation so that they can advertise their products, raise capital and access public goods. Notice that this view predicts that managers and assets are matched through a process that results in low ability managers being paired with low quality assets. Therefore, informal and formal firms are operating in different markets and have different customers so they do not compete against each other. Since informal firms provide livelihoods to millions of people, government policies should not raise the costs of doing business for them. Instead, the role of government policies should be to promote the creation of official firms and let the informal ones die as the economy develops.

The research findings tend to support the dual view. Unofficial firms use lower quality inputs and have less access to public goods and finance, and in return avoid taxation and additional regulatory burdens. Extremely few of the registered firms ever operated as informal firms suggesting that the two groups live in different worlds. This is also reflected in the enormous productivity gap between unofficial firms and small official firms (in terms of value added or sales per employee).

Additionally, the authors note that informal firms see lack of access to markets and finances as their biggest problem. The legal system, regulations and registration procedures do not rank as highly as obstacles to doing business among either formal or informal firms (this approach seems to run against the one taken by the Doing Business department of the World Bank). Finally, there is little evidence that unregistered firms pose a competitive threat to registered one–thus rejecting the parasite view.

This does not mean that informal firms are not relevant in developing countries. They are extremely important and that is why putting them out of business through more stringent enforcement would devastate the livelihoods of millions of people living near subsistence. Strategies that allow them to become more productive, such as microfinance, are desirable from the viewpoint of poverty alleviation, but are not growth strategies.

In lieu of these results, since there is such a productivity gap between formal and informal firms and considering that there is no evidence that informal firms become formal as they grow, the authors state that stimulation of formal firms is necessary for economic growth.The evidence points out that a best move would be to support the creation of formal firms run by educated managers and utilizing modern practices to stimulate economic development–something that, by the way, very much aligns with Acumen Fund’s view.